Debt Flagged by Fed Bought by Funds Copying 2007: Credit Markets

The Marriner S. Eccles Federal Reserve building stands in Washington, D.C. The Fed is now seeking to curb risk by updating guidance on best-underwriting practices for loans. Photographer: Andrew Harrer/Bloomberg

March 25 (Bloomberg) -- Money managers from Ares Management
LLC to Onex Corp. are borrowing at the fastest pace in six years
to buy the type of speculative-grade loans that federal bank
regulators warned last week is becoming riskier.

Ares, which oversees $59 billion, and Onex’s credit unit
are among firms that have raised $22.9 billion of
collateralized-loan obligations this quarter, approaching the
all-time high of $26.4 billion in the three months ended June
30, 2007, according to Royal Bank of Scotland Group Plc.
Leveraged-loan mutual funds have received their two biggest
weekly inflows since January.

At the same time the Federal Reserve’s zero interest-rate
policy is encouraging investors to seek ever-riskier debt assets
to generate returns, some members of the central bank are also
saying the market may be overheating. The Fed is now seeking to
curb risk by updating guidance on best-underwriting practices
for loans.

“What the Fed is trying to say is, ‘We know that demand is
there, we’ve created that demand, but we don’t want you to take
advantage of that demand to hurt us in the future,’” said
Matthew Duch, an investment manager who helps oversee $12
billion in assets at Bethesda, Maryland-based Calvert
Investments Inc. “The leverage in the system, while it may be
OK now, unwinding it when money starts to flow to other places
may be the problem.”

Ares Fund

Ares, based in Los Angeles, is also planning a closed-end
fund that will use borrowed money to buy mostly high-yield loans
and bonds, according to a March 20 regulatory filing, as federal
banking agencies say the quality of the debt is deteriorating.
The $4.5 billion that was raised for closed-end credit funds
this year through March 5 was the most for the period since
2007, according to Miami-based Thomas J. Herzfeld Advisors Inc.

CLO issuance soared to $7.4 billion this month, $900
million more than February, helping this year’s sales surpass
the $22.6 billion sold in the fourth quarter, according to RBS
strategists Richard Hill and Ken Kroszner.

“This is the kind of thing that happened before the
crisis, when the market was artificially inflated because of the
leveraged buyer in the space,” Frank Ossino, a Hartford,
Connecticut-based money manager who oversees $2 billion of
leveraged loans at Newfleet Asset Management, said in a
telephone interview. “We are approaching that excess and that’s
the kind of thing we need to watch.”

Default Swaps

Elsewhere in credit markets, the cost of protecting
corporate debt from default in the U.S. rose. The Markit CDX
North American Investment Grade Index, which investors use to
hedge against losses or to speculate on creditworthiness,
climbed 0.1 basis point to a mid-price of 90.5 basis points as
of 11:21 a.m. in New York, according to prices compiled by
Bloomberg.

The index typically rises as investor confidence
deteriorates and fall as it improves. Credit-default swaps pay
the buyer face value if a borrower fails to meet its
obligations, less the value of the defaulted debt. A basis point
equals $1,000 annually on a contract protecting $10 million of
debt.

The U.S. two-year interest-rate swap spread, a measure of
debt market stress, fell 0.17 basis point to 17.31 basis points
as of 11:22 a.m. in New York. The gauge narrows when investors
favor assets such as company debentures and widens when they
seek the perceived safety of government securities.

GE Bonds

Bonds of General Electric Co. are the most actively traded
dollar-denominated corporate securities by dealers today,
accounting for 5.3 percent of the volume of dealer trades of $1
million or more as of 11:27 a.m. in New York, according to
Trace, the bond-price reporting system of the Financial Industry
Regulatory Authority. GE Capital Corp. may issue fixed- and
floating-rate bonds as soon as today, according to a person
familiar with the transaction.

The Standard & Poor’s/LSTA U.S. Leveraged Loan 100 Index
rose 0.07 cent last week to 98.23 cents on the dollar, reaching
the highest level since July 22, 2007, and up from 96.09 at
year-end. The measure, which tracks the 100 largest dollar-denominated first-lien leveraged loans, has returned 1.97
percent this year.

Leveraged loans and high-yield, high-risk, or junk, bonds
are rated below Baa3 by Moody’s Investors Service and lower than
BBB- at S&P.

Risk Decision

Banks that have shepherded $217 billion of dollar-denominated leveraged loans this year into the market need to
orchestrate the financing in a “safe and sound manner” as non-regulated investors are willing to accept looser terms and
“prudent underwriting practices have deteriorated,” according
to a March 21 notice from federal bank regulators.

While banks are responsible for educating investors about
deal terms, the burden is on buyers to determine the risk
involved, said A.J. Murphy, co-head of global leveraged finance
at Bank of America. The firm is the largest underwriter of
leveraged loans in the U.S., Bloomberg data show.

“We understand the tension and pressure that drives
investors to take more risk,” she said in a telephone
interview. “Ultimately, the institutional investor makes the
decision in terms on how much risk to bear and where it
prices.”

Loan Funds

Four years after the Fed began holding benchmark borrowing
costs between zero and 0.25 percent to rescue the world’s
biggest economy from the credit crisis, concern is mounting that
debt yields at about record lows aren’t compensating investors
for their risk.

Investors are accelerating flows into funds that focus on
leveraged loans, which are ranked higher than corporate bonds in
a borrower’s capital structure in case of a bankruptcy and are
better protected from rising interest rates because they
typically are pegged to floating-rate benchmarks. The value of a
fixed-rate security diminishes with an increase in rates.

U.S. loan funds reported $1.4 billion of deposits last
week, the second-most behind the $1.5 billion received in the
second week of February, according to Bank of America Corp.

Onex, Canada’s largest publicly listed buyout firm, is
expanding its efforts to issue CLOs, selling at least $512.1
million of the debt this month, Bloomberg data show. CLOs are a
type of collateralized debt obligation that issue securities of
varying risk and return and use the proceeds to buy pools of
high-yield, high-risk loans.

‘Important Source’

“We’re very keen to continue growing that business,” Seth
Mersky, a senior managing director at Toronto-based Onex, said
in a phone interview on March 13. “It will be an important
source of assets under management and fees.”

The Ares Multi-Strategy Credit Fund would invest at least
60 percent of its assets in speculative-grade loans and bonds
and as much as 40 percent in CLOs and other asset-backed
securities, and would incur leverage equal to about 33 percent
of managed assets, according to the March 20 filing.

Yields on junk bonds globally dropped to a record low 6.3
percent on March 15, Bank of America Merrill Lynch index data
show, even as the strength of covenants governing the notes fell
to the lowest in at least two years as measured by Moody’s.

The average covenant score for speculative-grade bonds, in
which 1 is the strongest and 5 is the weakest, was 3.96 in
February, the lowest since the ratings company began tracking
the data in January 2011, Moody’s said March 12.

‘Very Robust’

Companies in the U.S. obtained more than $31 billion of
covenant-light loans in February, compared with the previous
peak of $23.4 billion in April 2007, Bloomberg data show. The
loans have fewer safeguards such as limits on how much debt a
company can add to its balance sheet.

Fed Governor Jeremy Stein has warned that some credit
markets, such as corporate debt, are showing signs of
potentially excessive risk-taking. In a speech in St. Louis on
Feb. 7, Stein cited leveraged loans and junk bonds as areas that
have been “very robust of late.”

Esther George, president of the Federal Reserve Bank of
Kansas City, spoke about the elevated price of assets such as
high-yield and leveraged loans in a speech Jan. 10.

“This is the Fed’s way of telling us that you are putting
your beer goggles back on,” he said, referring to the alcohol-induced state in which appearances are improved. “The Fed is
saying you guys need to wake up.”